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Economic Commentary

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California Is Rolling With The Punches

Mon, Oct 22 2007, 11:06 GMT
by Adam York, Mark Vitner

Wells Fargo Investments, LLC

California’s Economy Is Proving Remarkably Resilient

When you think of California’s economy today one of the first thoughts to come to mind is the collapsing housing market. California was one of the biggest participants in the housing boom and is now seeing the backside of that. Home sales are plummeting and prices are falling in many metro areas. The broader economy is assumed to be following the same route. Fortunately, it is not. Overall job growth is holding up relatively well and the Golden State’s Gross Domestic Product is still expanding. We estimate that California’s real GDP grew at a 2.8 percent annual rate during the third quarter and rose 3.7 percent over the past year.

Not only has overall growth held up relatively well to date but we expect the economy to continue to post solid gains over the next couple of years. This is not to say that the sharp reduction in new home construction will not have an impact. It most certainly has and will continue to do so. Employment in construction is currently off 2.6 percent over the past year and expected to fall further. Employment in related industries, including mortgage finance, is also weakening. Several other areas, including health care, education, leisure and hospitality, and wholesale trade and distribution, continue to do quite well. Defense, aerospace and the state’s key technology sectors also continue to expand.

The problems in mortgage finance are disproportionably affecting the California labor market. Nearly forty percent of recent layoffs were in credit intermediation and related activities. Through August, California has reported 42 percent more initial claims for unemployment insurance in the industry than in all of 2006. Obviously, credit market turmoil continued into September and we would expect the mass layoffs to get worse before they get better.

On a relative basis, the strongest job growth continues to be in the Inland Empire. Hiring is being driven by the burgeoning foreign trade sector. San Francisco and the greater Bay area, on the other hand, have taken much longer to recover from the last recession. San Francisco lost nearly ten percent of its nonfarm jobs in the three years including and following the 2001 recession, which hit the IT sector particularly hard. Sacramento saw the second strongest rate of improvement following the recession but hiring has slowed more recently, reflecting the relatively sharp contraction in homebuilding and mortgage finance currently taking place there.

Housing Inventory

The inventory overhang in California housing is severe at this point and has shown no signs of declining in the near-term. While the months’ supply of existing homes for sale has not reached the highs of the early 1990s after the last California housing bust, the pace of assent has them rapidly approaching those levels. The massive inventory overhang and California’s low affordability leads us to believe that activity on new homes will have to decline further from their already depressed levels and prices may have to decline substantially in order for balance to be restored in the market.

Prices will fall in both nominal and real terms. We are expecting about a 16 percent nominal drop over the next three years. The OFHEO price data that we use to trace California’s home prices excludes most homes with Subprime and Jumbo mortgages. Once these homes are included, price declines will prove to be far more severe. Unfortunately, there is no statewide price index that incorporates this data.

Outlook

California’s economy will continue to lose momentum as the housing bust unfolds. The slowest period of economic activity will likely occur between now and the middle of 2008. This period should see the bulk of the cutbacks in residential construction and related industries, such as mortgage banking. Rising foreclosures will result in larger price declines during the coming year. California will likely see prices decline in nominal terms for at least the next couple of years and in real terms a few years beyond that.

The weakness in the housing market is impacting consumer spending. Sales of motor vehicles have weakened much more in California than they have in the rest of the country. Sales are also off sharply at furniture stores and home improvement centers. Despite these declines, overall retail sales are still growing, reflecting solid income gains and a growth in tourism.

Once home construction bottoms out, economic growth will gradually pick back up, reflecting solid gains in international trade and the state’s large high technology sectors. We should see more balanced growth toward the end of the decade, with growth in business fixed investment helping drive output in the state’s IT equipment and software industries. The growing interest in green technologies is rapidly emerging as another key competitive advantage for California and could contribute meaningfully to growth in coming years.

While we expect conditions to gradually improve, the economic environment remains extremely challenging in California. High housing costs and rising energy bills are nudging many businesses and residents to neighboring states and, increasingly, to points even further out. Overall population growth has slowed significantly and will likely remain sluggish over the next few years. Slower population growth means that it will take longer to clear out the excess inventories of new homes currently on the market. A correction is underway, however, and we believe that the most painful part will be in the next few quarters.

Labor Market Has Weakened in Recent Months

California’s labor market has shown some weakness in recent months with nonfarm employment slowing to just 0.3 percent pace over the past three months. The deceleration reflects cutbacks in residential construction and mortgage finance, as well as an increasing reluctance by businesses to add staff.

California’s unemployment rate clearly bottomed in late 2006 and has risen 0.9 percentage points as the state economy took the brunt of the housing downturn and subprime mortgage market collapse in quick succession. Layoffs and job losses in both the construction and financial activities sectors are not over yet. Construction activity is still winding down throughout the state and we should see job losses accelerate later this year and early 2008. Layoffs in the financial sector took off in August and September and will take some time to work into the reported employment figures.

Coincident Index Indicates Moderate but Continued Growth

The coincident index has moderated in recent month, but is still growing solidly, climbing 2.8 percent over the past year. California’s economy has clearly experienced strong headwinds from the housing slump and more recently the mortgage market. Despite these problems the state is poised for moderate but continued growth. Population growth has slowed in recent years, but the state still added close to 300,000 people in 2006, the last year a Census estimate is available. The lack of affordable housing and a generally high cost of living continue to impede population growth.

Manufacturing exports slowed in the second quarter to just over $29 billion but remain near their recent highs. U.S. export strength on the whole should continue with a weaker dollar and strong growth abroad, as a result we would expect California’s exports will find the same favorable conditions in world markets.

Permits Are Off Sharply Since the Cycle Highs

Permits for new single family homes across the state are off sharply, down 34 percent in the last year and nearly two-thirds since the peak of the housing market. Single family permits are reaching levels not seen in more than a decade, as a severe inventory overhang plagues the California market. California housing has had and continues to have an affordability problem. While the premium that California’s home prices sell at relative to the nation using the OFHEO index averaged 11 percent between 1982 and 1998, the premium now stands at over 55 percent. Clearly this gap will need to close, at least modestly before housing will recover in the state. This convergence does not have to entirely be made of price declines in California, though we think double digit declines over the next few quarters are likely. Some of the correction will also come from slower price appreciation that the rest of the country in the out years.

Los Angeles

• The labor market remains steady in the Los Angeles area, while the unemployment rate has shown signs of bottoming out. Slow population growth coupled with modest gains in both nonfarm payrolls and household employment may combine to hold the unemployment rate near its current level.
• The size and diversity of the Los Angeles economy leave the city less exposed to the downturn in residential construction and housing that is plaguing many other parts of the state. Growth in defense and aerospace is helping offset some of the slowing elsewhere and international trade continues to grow rapidly.
• While Los Angeles may not have as high a cost of living as some California markets, such as San Francisco, the costs are still far higher than the nation as a whole. Home price affordability has made it a more expensive proposition for those considering a move to the area from less expensive markets out of state.
• Population growth, while still positive, has slowed for five straight years through 2006. Net migration has actually been negative for the last four years, as domestic emigration overwhelmed foreign immigration.
• Los Angeles is a major transportation hub for goods transiting from the Far East to the continental U.S. and increasingly from the U.S. to the Far East. The Port of Los Angeles is the nation’s largest container port and, when combined with the neighboring Port of Long Beach, ranks as the fifth largest container port in the world. These two ports moved more than ten percent of U.S. merchandise trade this past year. The strong traffic flow and shift to containerized ocean freight are creating demand for new industrial space and infrastructure.

Riverside

• The labor market appears to be weakening slightly with the unemployment rate having bottomed for this cycle, most likely. Payroll growth remains relatively firm, however, with growth rates well above the national average. Strong population growth may be contributing to the divergence, but the large number of workers who commute out of the area for work is also important. While household employment figures show nearly 1.74 million workers, the area reports just over 1.3 million nonfarm jobs, about 76 percent as many. With the vast transportation network linking Riverside to its western neighbors in the greater Los Angeles area, the two economies are closely interlinked.
• The growing importance of the region’s intermodal and transportation connections has created strong demand for industrial space and non-residential investment. Lying less than fifty miles to the east of the major ports in Los Angeles, Riverside is crisscrossed by two Class I rail systems and serves as the nation’s key distribution center for Asian imports.
• Overbuilding of new single-family homes was rampant in Riverside, as a result of the region’s rapid gains in population and employment. Building permits reached a high of nearly 60,000 units at an annualized rate in September 2005 and have since declined nearly seventy percent off that peak. Continued population gains and the relative lack of a boom in multi-family construction should help Riverside work through the glut of single-family homes faster than some other California markets.
• Population growth remains a key strength of the market, helping drive gains in retail trade, and business and professional services.

San Francisco

• While the unemployment rate has ticked-up in recent months, the labor market still appears to be in relatively solid shape. Solid yet unspectacular growth in employment continues, with both nonfarm and household employment growth outpacing the nation. The labor market was hit hard by the bursting of the tech bubble in the early part of the decade and employment growth did not return until 2005 on a sustained basis.
• Population growth also suffered in the aftermath of the tech bubble, with the population declining outright from 2002-2004. However, growth has returned to the region for the last two years, albeit at a slower pace than before. Many of the same obstacles remain for migrants looking to the Bay Area, namely an extremely high cost of living with very low housing affordability. The cost of the median home sold in San Francisco in 2007 was $827,000, which is among the highest for any metro area in the nation.
• Housing price growth has slowed in recent quarters after the second period of rapid growth in a decade. Housing prices grew at nearly a thirty percent pace in 2000, and again in 2004- 2005. While, we expect housing prices to continue to struggle for the next year or more in San Francisco, we do not see the same sized declines as we expect other areas. The market still has solid underlying support with renewed population growth and a technology sector that appears poised for an upswing in coming quarters. Land for new residential development remains scarce and entitlements are tough to come by.
• Demand for office space has been growing. Vacancy rates topped out at over 20 percent in mid 2003. Led by sharp declines in suburbs, the metro area vacancy rate fell to 8.5 percent in the third quarter, its lowest level in six and a half years.

Sacramento

• The labor market is clearly showing signs of weakness in Sacramento, unemployment rose to a 40 month high in August at 5.5 percent. In addition to layoffs in residential construction, several financial services firms have announced cutbacks recently. On the plus side, hiring has picked up in the tech sector.
• Residential construction has slowed considerably in recent months but will likely need to fall even further. Sacramento is seeing one of the largest increases in foreclosures and was one of the more active markets by speculators.
• Sacramento and the Central Valley are one of the most overbuilt markets in the state. New permits for single-family homes reached levels not seen since the mid-1990s in the wake of the last California housing bust. Housing prices have declined at an accelerating pace, quarter over quarter, for six straight quarters now and there are more declines to come.
• Population growth in the region has slowed considerably in recent years, but the region is still adding new residents at a solid pace. Sacramento, despite having a high cost of living relative to most of the country, is still affordable compared to the coastal regions of the state. This incentive will only be helped by the cities relatively early home price correction compared to other parts of the state and country.
• Government remains the cornerstone of the Sacramento economy. The government sector has traditionally played a stabilizing role in the labor force providing at least stable if not growing employment despite cyclical turns. This may at least be somewhat in doubt as tax revenue growth has slowed along with the California housing market.

San Diego

• San Diego may be more exposed to the housing market troubles than many other cities in California. Housing prices have been declining for almost a year now on an OFHEO basis, and while building activity is well off its highs it has yet to reach the lows seen in the last California housing bust in the early 1990s. San Diego may still have some room to decline over coming quarters on both the activity and price fronts as conditions will most likely get worse before they get better.
• The employment market has weakened considerably in the city this year. While, nonfarm employment continues to grow year over year, it has slowed notably, and the unemployment rate has been trending up for most of the year as well. The city does still have strong ties to the military and government contractors and this may provide some cushion on the employment front. That said it will be difficult for these factors to offset declines in construction and financial activities tied to the housing boom. These losses will get worse before they get better.
• Slower population growth may limit the rise in the unemployment rate, as housing affordability is an issue in San Diego just like most of the state. Demographics trends coupled with a slowing housing market may slow the economy to well under the pace of growth seen in recent years.
• San Diego’s key biotechnology sector continues to have strong momentum and remain a key competitive advantage for the region. Venture capital remains abundant for the industry.
• Office vacancy rates bottomed for this cycle at the end of 2005 and have risen almost three percentage points since then. San Diego’s high housing costs are causing many firms to look outside the region when they are expanding their operations.

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Published on  Mon, Oct 22 2007, 11:15 GMT